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Retirement Warning: The Safe Withdrawal Rate is NOT a Fixed Number

Beyond Buy-and-Hold #102

Retirement Warning: The Safe Withdrawal Rate is NOT a Fixed Number
Retirement Warning: The Safe Withdrawal Rate is NOT a Fixed Number

Valuation-Informed Indexing is shocking stuff. I don’t often have the experience of people offering informed rebuttals to what I say. In fact, I just about never see that. What I do see a lot of is people saying “that’s crazy!” or “You can’t really believe that!” or something along those lines.

Those arguments don’t sway me because I have been working this stuff a long time. I don’t go by first impressions. I go by research. There’s 30 years of academic research supporting Valuation-Informed Indexing. I’ve learned to tune out emotional reactions that are not in tune with the research. And just about all of the objections that I hear to this exciting new investing strategy fall into that category.

I relate to the feelings of those who experience shock, however. I have experienced some of those feelings myself at earlier times. I thought it might be helpful to share with you the graphic that provoked the greatest amount of shock that I have experienced in my ten years of developing and promoting the VII concept.

The “safe withdrawal” rate

The safe withdrawal rate (SWR) is the inflation-adjusted percentage of a portfolio that a retiree can take out each year to cover living expenses, assuming that he has the bad luck to experience the worst returns sequence we have seen in U.S. history. The idea is to tell aspiring retirees how much they need to save to be virtually certain that their plans will work. By looking at what happens in a worst-case scenario, we give aspiring retirees a highly conservative number to use in their planning.

Say that you retire with a portfolio of $1 million. The Old School SWR studies reported that the SWR is always 4 percent. So you would be able to take out $40,000 each year to cover living expenses. I am the person who discovered the errors in those studies; there is now a consensus in the field that I was right that they get the numbers wildly wrong. You cannot identify the SWR properly without taking the valuation level that applies on the day the retirement begins into consideration.

Unfortunately, there is NOT yet a consensus on how to calculate the SWR properly. I say that the way to do it is to run a regression analysis to determine how much valuations affect the result and then make the necessary upward or downward adjustments depending on whether valuations are low (requiring a upward adjustment) or high (requiring a downward adjustment).

Why is there no consensus? It’s not that there’s not a mountain of research supporting the New School approach to SWR analysis. There’s a mountain. The trouble is that the results you get when you perform the analysis are so darn shocking that a good number of prudent people just cannot get behind the idea.

As noted above, I was once with them, at least in spirit (I always believed that the data was telling us something important and that I just needed to work on my emotions until I understood the message a bit more clearly).

Here’s the shocking graphic:

Retirement Warning: The Safe Withdrawal Rate is NOT a Fixed Number
Retirement Warning: The Safe Withdrawal Rate is NOT a Fixed Number

In the old days, people were shocked that my SWR numbers were too low. The discredited studies and said that the SWR was always 4 percent and I was pointing out that the data shows that at times when stocks were priced as they were at the top of the bubble, the SWR can drop to as low as 1.6 percent. “These studies are going to cause millions of people to suffer failed retirements,” I used to note and people would say “Sure they are.”

You don’t hear that today. People understand today that 4 percent is not even a tiny bit safe for retirements that begin at the sorts of prices that applied prior to the crash. But there’s another finding generated by my calculator that still possesses the power to shock and dismay.

Safe withdrawal rate shocker: the rate depends on stock valuations

Look at Scenario One in the graphic. Scenario One identifies the SWR that applies not at a time when stock prices are insanely high but at a time when stock prices are insanely low. The P/E10 value used in that scenario is “8,” a P/E10 value we last saw in the early 1980s.

Look at that SWR! It’s over 9 percent! Holy moly!

Think what is being said here. The old studies said that you can always plan to take $40,000 per year out of a portfolio priced at $1 million. I said that at times of high valuations you need to lower your spending expectations to $16,000 per year. But my calculator reported a very different story at times of low valuations. At times of low valuations, the retiree who owns a portfolio of $1 million may take out over $90,000 per year to cover living expenses!

I couldn’t believe it either when the calculator first came out. I reported the number. I told people that it was the product of a regression analysis performed on the historical data. But I told people that I personally would never advise anyone to take $90,000 a year out of a $1 million portfolio. That’s just too crazy. It might sense to lower your withdrawal at times of high prices in the name of prudence. But it could hardly be prudent to take $90,000 out of a $1 million portfolio.

I don’t feel that way today. What the calculator reports is entirely prudent. Remember that the 9 percent number is the withdrawal that works in a worst-case scenario. The number that works in 50 percent of the return sequences that might pop up is 10.33 percent. There’s a tiny number of insanely lucky sequences under which a withdrawal of 12.13 percent would work. If you turn up bad cards, 9 percent will work in the circumstances examined in Scenario One.

But how can it be?

The safe withdrawal rate: long term timing is everything

Here’s a way to think about it that makes the shock go away, at least for me.

Stocks were priced at one-half fair value in 1982. Stocks were priced at three times fair value in 2000. Three times fair value is a multiple of six more than one-half fair value.

Round the 1.6 number that applied in 2000 to 1.5 to make the math easy. Now multiply by six. What do you get? 9 percent!

It’s not shocking that a 9 percent withdrawal is safe for a retirement that begins at the prices that applied in 1982. That’s just what we should expect to be the case.

We find the 9 percent number shocking because we have grown accustomed to the Buy-and-Hold way of thinking about things, a way of thinking about things that is now discredited by 30 years of academic research. 9 percent is a perfectly appropriate SWR when stocks are priced low. The problem has never been with the New School SWR calculations. The problem is with us and our inability to accept that we got it all so wildly wrong during the Buy-and-Hold years.

Rob Bennett favors watching pennies but not pinching pennies. His bio is here.

( Photo from Flickr by mvhargan )


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